Tuesday, July 17, 2012

Spain: A Cautionary Tale from Michael Pettis

Beijing-based economist Michael Pettis has family roots in Spain. Michael's personal experiences with friends and family involved in the Spanish real estate bubble provide object lessons on a much wider scale:

I remember in 2003 my mother had a New Year’s Eve party at our family home in Málaga, in southern Spain, at which over 80 people sat for dinner, including most of my old friends still around from high school days. That night I had one of those epiphanies (as you often do on New Year’s Eve, I guess) about the real estate market when I suddenly realized that nearly every one at the party was involved in one way or the other in real estate. Most of the people there (including my Persian sister-in-law) were real estate developers, real estate agents, real estate lawyers, architects, or owners of building and construction companies. All of them lived off (and had prospered mightily from) the real estate boom in southern Spain.

But this cannot be, I thought in my naiveté. If the only industry around is real estate, then we must be living through a real estate bubble of enormous proportions.

Later that night I spoke to one of my old high-school friends, Andy, who was at the time a prosperous real estate agent with houses in Marbella (purchased on borrowed money, naturally), a Mercedes, and all the trappings that accrue to an immensely charming and self-confident real estate agent during a real estate boom. In our conversations, and ones that took place subsequently over the next few years, I warned him that the property market in the south of Spain looked out of control, and it would be a good idea from him to diversify his savings out of real estate.

Same old same old

Of course Andy didn’t. He explained to me that what we were seeing in southern Spain was not a bubble because there were very strong reasons to believe that real estate prices were undervalued and were going to rise a lot more. Europe, he told me, is aging rapidly, and old people, as everyone knows, like nothing better than to retire in some warm and sunny place, preferably on the beach. With an infinite supply of European old people and limited European beachfront property, mostly in Spain, Italy, and Greece, where in addition you had great food, warm-hearted people, and plenty of immigrants to keep the prices of services (and servants) down, it was certain, Andy explained, that real estate prices would not decline. The demand was insatiable at almost any price.

This seemed like a perfectly reasonable argument on the face of it, and it was widely proposed to justify ever-soaring Spanish real estate prices for many years, not just on the Spanish coast but also, perhaps a little bizarrely, in every nook and cranny of the country, including some pretty gray and inaccessible building projects outside cold, northern industrial cities.

The weakness in the argument, of course, was that although there might have been near-infinite demand, this could not justify near-infinite increases in prices, especially since the demand itself was likely to be highly pro-cyclical because the Spanish economy had itself become dependent on real estate development. As long as the economies of the cold northern European countries were booming, in other words, the demand from retirees for beach houses would stay high, but any slowdown in the economy would reduce demand in Spain at the worst possible time.

And as Spanish real estate slowed, the impact would be exacerbated by a much sharper slowdown in the Spanish economy caused by the slowdown in real estate, which had become a major driver of the economy. If a substantial portion of the Spanish workforce depends on a booming real estate market – and not just those directly dependent, but also those indirectly dependent, like bankers, restaurateurs, retailers, travel agents, and so on – then any slowdown in the real estate sector is itself seriously self-reinforcing.

We have now seen how this works in Spain, but in China we are still using a similar argument to explain why real estate prices cannot drop significantly. Our Chinese version of the old-people-love-to-live-on-the-beach argument is the urbanization argument. As long as Chinese workers continue to move from the country to the cities – and urbanization has been one of the most dramatic consequences of Chinese growth in the past three decades – then there is likely to be a near infinite demand for city property, and so prices can only go up. And because prices can only go up, speculative demand for real estate is not speculative, it is precautionary.

This claim seems at least as plausible as the Spanish argument justifying infinite price increases, and was probably true a decade ago, but it runs into the same problem that the Spanish story ran into (and indeed that nearly every previous case in history of a real estate bubble, which has always started with a plausible story). First, no matter how much demand we can project into the future, rising prices can nonetheless outpace rising demand because rising prices can themselves stimulate further demand, in which case rising prices are unsustainable. This should be obvious, but the point is often lost in the giddiness that accompanies rapidly rising prices.

Second, and this is key, the rising demand is itself pro-cyclical. This is the most dangerous part of the process and perhaps the least well understood. Rising demand driven by the urbanization process is itself subject to underlying growth in the economy, since it is growth in turn that drives the urbanization process.

What’s more, when we reach the point as we did in Spain several years ago, and have reached in China too, in which a substantial part of the growth that drives the urbanization process is itself created by real estate development, then any slowdown in underlying growth is likely to be seriously exacerbated by a corresponding slowdown in real estate development. This is because the economy is caught in the reverse side of the feedback loop that helped drive prices on the way up – slowing growth leads to slower demand for urban real estate, which leads to slower real estate development, which itself leads to slower growth. _Michael Pettis

Most of the developed world is caught up in the twin destructors of exponentially rising debt, and demographic decline. Up until recently, it was thought that China, India, Brasil, and Russia were exceptions to this widespread decline. But that rosy viewpoint may be wrong.

In fact, it seems that the Anglosphere may be in the best position to weather this lengthening global recession, if the US can rid itself of the parasitic regime that is currently sucking the life's blood out of the US private sector.